FINANCIAL AFFAIRS: Ruby anniversary of demise of gold-backed currency

The gold standard (that is, a gold-backed currency) was just a “barbarous relic”, according to the 20th-century’s most influential economist, John Maynard Keynes.

But if the gold standard is just an outdated relic, why has the price of gold soared to over US$1,800 an ounce, a level it hasn’t seen in decades?

And why have calls for a return to the gold standard been such a big issue in the Republican Party nomination race for the U.S. presidency?

The reason is that people don’t trust paper money in times of economic distress. Gold has functioned as a store of value, a unit of account and a means of conducting transactions since the dawn of human history. Beyond acting as a precious metal and as jewellery, which in most societies is more or less the same thing, gold has few other uses, which is one of its attractions. Gold is malleable, easily divisible, virtually indestructible, its supply is limited and it can be stored for centuries — or even sunk in the depths of the ocean — without the slightest hint of degradation.

Metals such as gold, silver and copper acted as currency for centuries. The Chinese used a type of coin called a “cash” (from whence comes our modern word). This was a round, low-value copper coin with a hole in the middle, enabling users to string them together in order to carry sums of higher denominations. To this day, Chinese cash coins can be found in every flea market in Asia.

The relative exchange value between gold and silver was often extremely unstable, and controversies over bimetalism, the relationship between gold and silver, dominated United States politics from the 1830s to the 1920s.

Paper money has been around for thousands of years — another Chinese invention — but usually it has been backed, at least in theory, by gold or silver. Today, all currencies are fiat money (i.e., not backed by a physical commodity).

In the past, pure fiat money not backed by gold has always failed. The only backing that fiat money has is the issuing government’s pledge not to devalue it through inflation. And governments have proved to be very poor custodians of their currencies.

Historically, fiat money regimes have proved to be almost universally disastrous. During the reign of Louis XV, the Scottish economist John Law was appointed France’s Controller-General of Finances. In 1716 he established the country’s Banque Générale and embarked on an innovative paper-money scheme which helped create the 1718-1720 Mississippi Bubble. This ruined the Ancien Régime’s finances, weakened the monarchy and indirectly led to the French Revolution, which broke out 15 years after Louis XV’s death.

During the 1861-65 American Civil War, a major contributing factor to the North’s defeat of the South was when the Union captured New Orleans. This meant that the Confederacy couldn’t get its cotton to market, thus rendering the “cotton bonds” it was using to finance its war effort worthless. The Confederacy’s profligate issuing of paper money, to the extent that by the end of the war, a Confederate dollar had fallen to 1/50th of the gold value of Yankee dollar, hastened the South’s downfall.

And if you think that has no relevance to Australia, consider the following example. Note Printing Australia (NPA), where the Reserve Bank of Australia prints all of Australia’s polymer banknotes, is in Craigieburn, in Melbourne’s northwestern suburbs. Until only recently, the public could visit and watch the notes being printed.

The last time I visited was just before Christmas. I asked the guide, “The presses seem to be very busy today. Why is that?”

“Oh, Christmas is coming up,” she said. “So people need more money.”

Before my eyes, the NPA was creating money simply by cranking up the printing presses and running them for an extra shift: it was creating fiat money. It only had value because the government said it had value.

All money in the world is now fiat money. The Swiss franc was the last gold-backed currency. Before 2000, at least 40 per cent of all Swiss currency had to be backed by gold. The whole international monetary edifice, including the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IFRD), better known as the World Bank, which had been created in the Bretton Woods agreements in 1944, once depended on gold. Or to be more specific, it depended on the United States acting as the world’s banker and maintaining the “gold window”, where foreign governments could exchange dollars for gold.

In 1970, the Vietnam War was flooding the world with dollars, and Lyndon Johnson’s Great Society welfare programs were expanding the U.S. money supply by an inflationary 10 per cent a year. In response, the Swiss and French were exchanging massive volumes of U.S. paper dollars for U.S. gold.

The end result was the “Nixon shock”. On August 15, 1971, just over 40 years ago, U.S. President Richard Nixon closed the gold window. Gold was no longer to be the basis of the international monetary system.

But have no doubt, whether or not you regard gold-backed money as a “barbarous relic”, the enduring political attraction of the idea is still very much with us.